Annuity Withdrawal Rules: Taxes, Penalties, and Surrender Charges

Annuity withdrawal rules apply in two layers. First, the insurance company can impose a surrender charge on money you pull out above a set annual allowance during the contract’s early years. Second, the IRS taxes the earnings portion of your withdrawal as ordinary income and adds a 10% penalty if you’re under 59½. Both layers stack, and the total cost depends on your age, how long you’ve held the contract, and whether the annuity was funded with pre-tax or after-tax dollars.

What the Insurance Company Charges

Before the IRS gets involved, your insurer applies its own contract terms. The main cost is the surrender charge, a fee the insurance company levies when you withdraw more than a set annual amount or cancel the contract during a window that typically runs five to ten years from purchase. The charge exists because the insurer paid a large upfront commission to the agent who sold the contract and needs time to recover that money through investment returns on your premium.

Surrender charges usually start between 6% and 8% of the amount withdrawn and decline by roughly one percentage point per year until they reach zero. A seven-year schedule might run 7% in year one, 6% in year two, and so on, with the charge disappearing entirely by year eight. The schedule is locked in when you sign, and it doesn’t move with market conditions or your circumstances.

The Free Withdrawal Allowance

Nearly every deferred annuity includes a free withdrawal allowance, commonly set at 10% of the account value as of the most recent contract anniversary or 10% of total premiums paid. Withdrawals within that threshold avoid the surrender charge entirely. Anything above it triggers the charge on the excess only.

Market Value Adjustments

Some fixed and fixed-indexed annuities include a market value adjustment (MVA) that raises or lowers your withdrawal value depending on how interest rates have moved since you bought the contract. Rising rates cut what you receive; falling rates work in your favor. The MVA applies only to amounts above the free withdrawal allowance and only during the contract’s guarantee period.

Hardship Waivers

Many contracts include riders that waive the surrender charge under specific conditions. The most common waivers apply when the owner is confined to a nursing home or assisted-living facility for at least 90 consecutive days, or when the owner is diagnosed with a terminal illness. Some contracts also waive charges for home health care or hospice services. These waivers are not required by federal law; they’re negotiated contract features that vary by insurer. Read the rider language in your specific policy to see what applies.

One catch: amounts withdrawn under a hardship waiver typically reduce the free withdrawal allowance for the same contract year. And even if the insurer waives its surrender charge, the IRS still applies its tax rules to the distribution.

How the IRS Taxes the Withdrawal

The tax side depends on how the annuity was funded.

Non-Qualified Annuities (After-Tax Dollars)

A non-qualified annuity is a contract you purchased with money you’d already paid tax on. The IRS applies an earnings-first rule to withdrawals: every dollar you take out is treated as coming from untaxed investment gains until those gains are exhausted. Only after all accumulated earnings have been withdrawn does the IRS treat further distributions as a return of your original premium, which isn’t taxed again.¹

The rule sits in 26 U.S.C. § 72(e): any amount received before the annuity starting date is allocated to income on the contract first, up to the excess of the contract’s cash value over your investment in the contract. Everything beyond that is a tax-free return of your cost basis.²

The earnings portion is taxed at your ordinary income rate, not the lower capital gains rate, no matter how long the money has been invested.¹

One trap to know about: if you own multiple non-qualified annuity contracts issued by the same insurance company in the same calendar year, the IRS treats them as a single contract for withdrawal purposes. You can’t split money across several contracts with the same insurer and selectively pull from the one with the lowest gains. Contracts issued by different companies are not aggregated.²

Qualified Annuities (Pre-Tax Dollars)

Qualified annuities sit inside tax-advantaged accounts like traditional IRAs, 401(k)s, or 403(b) plans. Because contributions were made with pre-tax dollars, the earnings-first split doesn’t apply. Every dollar you withdraw is fully taxable as ordinary income. There’s no cost basis to recover tax-free because you never paid tax on the money going in.¹

The exception is after-tax contributions some plans allow. If your account holds any after-tax basis, a portion of each withdrawal comes back tax-free. Your plan administrator can confirm whether that applies to you.

The 10% Early Withdrawal Penalty

On top of ordinary income tax, the IRS adds a 10% penalty on the taxable portion of any annuity withdrawal taken before you turn 59½. For non-qualified annuities, the penalty applies only to earnings, since your cost basis isn’t taxable. For qualified annuities, where the whole withdrawal is taxable, the 10% applies to the full amount.²

In practical terms: at 50 years old, in the 22% bracket, a $20,000 earnings withdrawal from a non-qualified annuity costs $4,400 in income tax plus a $2,000 penalty. That’s $6,400, or 32% of the withdrawal, before any surrender charge from the insurance company. The insurer’s charge and the IRS penalty stack.

Exceptions That Waive the 10% Penalty

The tax code carves out several situations where the penalty is dropped. These exceptions eliminate only the penalty. You still owe ordinary income tax on the taxable portion, and any surrender charge still applies.

For non-qualified annuity contracts under 26 U.S.C. § 72(q):²

Distributions to a beneficiary after the owner dies.
Distributions after the owner becomes permanently and totally disabled.
Substantially equal periodic payments (SEPPs) based on life expectancy, which must continue for at least five years or until you reach 59½, whichever is longer. Modifying the schedule before that window closes triggers retroactive penalties plus interest on every prior distribution.
Payments from an immediate annuity that begins payouts within one year of purchase.

Qualified annuities inside employer plans get additional exceptions under 26 U.S.C. § 72(t):³

Separation from service during or after the year you turn 55 (age 50 for public safety employees of state or local governments). This does not apply to IRAs or non-qualified annuities.
Unreimbursed medical expenses exceeding 7.5% of adjusted gross income.
Up to $5,000 per child for qualified birth or adoption expenses.
Distributions to an individual certified by a physician as having a condition expected to result in death within 84 months.
Domestic abuse distributions up to the lesser of $10,000 (indexed for inflation after 2024) or 50% of the vested account balance, if taken within one year of the abuse.

The SEPP option deserves extra caution. It works for people who need steady income before 59½ and can commit to the schedule for years. If your situation changes and you alter the payments too early, the IRS recaptures every penalty you avoided plus interest.

Required Minimum Distributions on Qualified Annuities

Qualified annuities are subject to Required Minimum Distributions. Once you reach the applicable age, the IRS requires you to start withdrawing whether you need the money or not. The current RMD starting age is 73 for people born between 1951 and 1959, and 75 for people born in 1960 or later.⁴

Your first RMD can be delayed until April 1 of the year after the year you reach the triggering age. Every RMD after that must be taken by December 31. If you delay the first one, you’ll owe two RMDs in that second calendar year, which can push you into a higher bracket.

Missing an RMD costs a 25% excise tax on the amount you should have withdrawn. That drops to 10% if you correct the shortfall within two years by taking the missed distribution and filing Form 5329.⁵

Non-qualified annuities are not subject to RMDs during the owner’s lifetime. Distribution requirements kick in only after the owner dies.

When the Owner Dies: Beneficiary Withdrawal Rules

Rules shift when an annuity passes to a beneficiary, and they split by contract type.

Non-Qualified Contracts

When the owner dies before the annuity starting date, the entire contract must be distributed within five years. A designated beneficiary can instead take payments over their own life expectancy if those payments begin within one year of the owner’s death, which satisfies the five-year rule.⁶

A surviving spouse who is the designated beneficiary can step into the owner’s shoes and be treated as the new contract holder, effectively resetting the clock. Non-spouse beneficiaries choose between the five-year payout and the life-expectancy method. Gains still come out first and are taxed as ordinary income to the beneficiary, but the 10% early withdrawal penalty does not apply to inherited annuity distributions, regardless of the beneficiary’s age.

Qualified Contracts

Beneficiaries of qualified annuities follow the SECURE Act rules. A surviving spouse can roll the inherited annuity into their own IRA. Most other individual beneficiaries must empty the account by December 31 of the tenth year after the owner’s death.⁷

A narrow group of eligible designated beneficiaries can still stretch distributions over their own life expectancy: minor children of the deceased owner (until they reach the age of majority), individuals who are disabled or chronically ill, and beneficiaries who are no more than 10 years younger than the deceased owner.⁷

Ways to Move Money Without Triggering Tax

1035 Exchanges

If you’re unhappy with your annuity’s performance, fees, or features, you don’t have to cash it out. Section 1035 of the Internal Revenue Code lets you exchange one annuity contract for another without recognizing any gain or loss. You can also exchange an annuity for a qualified long-term care insurance contract under the same provision.⁸

The transfer must move directly from the old insurer to the new one. If the money passes through your hands, the IRS treats it as a withdrawal, not an exchange, and taxes the gains. The contract owner must remain the same on both contracts.⁹

A partial 1035 exchange lets you move some of the value into a new contract while keeping the original active. The IRS requires that no withdrawals be taken from either contract during the 180 days following the transfer. Pulling money out during that window can cause the IRS to reclassify the entire transaction as a taxable distribution.¹⁰

A 1035 exchange sidesteps the tax hit but not necessarily the old contract’s surrender charge. If you exchange within the surrender period, the original insurer may still apply the charge to the transferred amount. Some new contracts offer bonus credits to offset that cost, though those bonuses often come with their own longer surrender periods.

Annuitization

You can also convert your annuity into a guaranteed stream of income through annuitization. This is irrevocable: once you annuitize, you give up access to the lump-sum account value in exchange for periodic payments that continue for a defined period or for life. Common payout structures include life only, life with a period certain of 10 or 20 years, and joint and survivor.

For non-qualified contracts, annuitization gets more favorable tax treatment than lump-sum withdrawals. Instead of the earnings-first rule, the IRS uses an exclusion ratio that spreads your cost basis recovery evenly across the expected payment period. You divide your investment in the contract by the total expected return; that percentage of each payment comes back tax-free. Once your total tax-free payments equal your original investment, every subsequent payment becomes fully taxable.¹¹

Payments from a qualified annuity funded entirely with pre-tax dollars are fully taxable from the first payment. There’s no exclusion ratio because there’s no after-tax basis to recover.

Withholding on Your Distribution

Annuity distributions are subject to federal income tax withholding unless you affirmatively elect out. The insurer withholds at a default rate and reports the amount on a 1099-R. If you opt out, you may need to make estimated tax payments through the year to avoid an underpayment penalty at filing.¹¹

Mandatory 20% withholding applies to eligible rollover distributions from qualified plans paid directly to you rather than transferred to another qualified plan or IRA. If you want to avoid the automatic 20%, request a direct rollover to the receiving account instead of taking possession of the check.

1
Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income
2
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
3
Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
4
Congress.gov. Required Minimum Distribution (RMD) Rules for Original Owners
5
Internal Revenue Service. Retirement Plan and IRA Required Minimum Distributions FAQs
6
Office of the Law Revision Counsel. 26 U.S. Code 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
7
Internal Revenue Service. Retirement Topics – Beneficiary
8
Office of the Law Revision Counsel. 26 USC 1035 – Certain Exchanges of Insurance Policies
9
Internal Revenue Service. Part I Section 1035 – Certain Exchanges of Insurance Policies
10
Internal Revenue Service. Rev. Proc. 2011-38, Section 1035
11
Internal Revenue Service. Publication 939 (12/2025), General Rule for Pensions and Annuities